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My pet hypothesis is that the market is pricing in a large amount of expected near-term inflation. In other words, it's not that the market thinks that companie

My pet hypothesis is that the market is pricing in a large amount of expected near-term inflation. In other words, it's not that the market thinks that companies are not going to lose much value due to the COVID-19 pandemic, it's that the market expects that the dollar will lose almost as much value as the average company. Share price is an exchange rate between dollars and fractions of ownership of a company - it goes up when the value of the company goes up, and also goes up when the value of the dollar goes down. Of course take this hypothesis with a large grain of salt - I'm pretty sure there exist ways to figure out expected inflation, but I'm not sure what they are. Specifically, if I knew of something like a Consumer Price Index futures market, that would fairly definitively answer my question of whether expected inflation is a large part of why the stock market is priced so high relative to the dollar. Absent something like that, I have no strong evidence for or against my pet hypothesis (if you know of something like that, please do let me know).

nkurz 6y ago
I think your hypothesis explains part but not all of the situation. Complicating things, inflation is surprisingly hard to measure. One of the main components of CPI is rent (or rent equivalent for homeowners). It seems unlikely that rents are going to skyrocket anytime soon, which means that by the official measure, in the short term deflation might actually be more likely than inflation. If you are looking for "futures" on CPI, you should probably look at the pricing for TIPS (Treasury Inflation Protected Securities). There was a new issuing of a 5-year TIPS a couple weeks ago, and the pricing was about the lowest ever. Which is to say that the market expects very low inflation as measured by CPI-U: https://tipswatch.com/2020/04/23/real-yield-on-new-5-year-tips-dips-deeply-negative-at-0-32/ https://tipswatch.com/2020/04/23/real-yield-on-new-5-year-ti....
- JoshuaDavid 6y ago
  The pricing for TIPS looks like exactly what I was looking for, thanks! So that is pretty strong evidence against my pet hypothesis that the market expects that a dollar in the future will buy less value. While I suppose it is _possible_ that the expectation is that the cost of things not included in the CPI's basket of goods will increase much faster than the cost of things included in the CPI's basket of goods, that seems like quite a stretch, and I see no particular reason COVID would make that more the case now than it was 3 months ago. At this point I am very confused about current market valuations. The market is only down around 10% from its peak valuation, implying that people smarter than I am think that the combined effects of the shutdown of large parts of the economy for an indefinite period plus whatever downstream effects the resulting bankruptcies / disruption have only reduce the collective net present value of publicly traded companies by around 10%. As a layperson I wouldn't be surprised to see fully 10% of publicly traded companies by market cap go bankrupt, which I expect would eliminate that 10% of NPV right then and there. But right now if you think there's a better than 50% chance of a 10% drop in the S&P 500 before the end of the year, you can make a killing on stock options (sell puts at ~330 to ~340). So clearly people are putting their money where their mouth is when it comes to betting that COVID won't have further massive impacts, so I must be missing something. I'm really wondering what I'm missing though. Maybe 10% of companies by market cap going bankrupt is actually really implausible, or maybe there's an expectation that existing publicly traded companies will expand to fill in the niches left by the companies that die off. It's kind of maddening not understanding what's going on though.

nkurz 6y ago

I think your hypothesis explains part but not all of the situation. Complicating things, inflation is surprisingly hard to measure. One of the main components of CPI is rent (or rent equivalent for homeowners). It seems unlikely that rents are going to skyrocket anytime soon, which means that by the official measure, in the short term deflation might actually be more likely than inflation. If you are looking for "futures" on CPI, you should probably look at the pricing for TIPS (Treasury Inflation Protected Securities). There was a new issuing of a 5-year TIPS a couple weeks ago, and the pricing was about the lowest ever. Which is to say that the market expects very low inflation as measured by CPI-U: https://tipswatch.com/2020/04/23/real-yield-on-new-5-year-tips-dips-deeply-negative-at-0-32/ https://tipswatch.com/2020/04/23/real-yield-on-new-5-year-ti....

JoshuaDavid 6y ago
The pricing for TIPS looks like exactly what I was looking for, thanks! So that is pretty strong evidence against my pet hypothesis that the market expects that a dollar in the future will buy less value. While I suppose it is _possible_ that the expectation is that the cost of things not included in the CPI's basket of goods will increase much faster than the cost of things included in the CPI's basket of goods, that seems like quite a stretch, and I see no particular reason COVID would make that more the case now than it was 3 months ago. At this point I am very confused about current market valuations. The market is only down around 10% from its peak valuation, implying that people smarter than I am think that the combined effects of the shutdown of large parts of the economy for an indefinite period plus whatever downstream effects the resulting bankruptcies / disruption have only reduce the collective net present value of publicly traded companies by around 10%. As a layperson I wouldn't be surprised to see fully 10% of publicly traded companies by market cap go bankrupt, which I expect would eliminate that 10% of NPV right then and there. But right now if you think there's a better than 50% chance of a 10% drop in the S&P 500 before the end of the year, you can make a killing on stock options (sell puts at ~330 to ~340). So clearly people are putting their money where their mouth is when it comes to betting that COVID won't have further massive impacts, so I must be missing something. I'm really wondering what I'm missing though. Maybe 10% of companies by market cap going bankrupt is actually really implausible, or maybe there's an expectation that existing publicly traded companies will expand to fill in the niches left by the companies that die off. It's kind of maddening not understanding what's going on though.